Option ARM Losses May Be Less Than Feared

Most economists who follow option adjustable-rate mortgage loans think that there’s a whole lot of reset risk associated with these instruments over the next couple of years. But what if that thinking is wrong?

While there isn’t yet enough evidence to toss out conventional wisdom—and conventional wisdom understated portfolio stresses in the past few years, rather than overstated it—there are some data points that an economist at Lord Abbett & Co. LLC says point to a less dour outlook.

“It will not be pleasant, but it is not the end of the world or anything close to it,” said Milton Ezrati, a partner, senior economist and market strategist at Lord Abbett, the Jersey City, N.J.-based money management firm. According to figures he got from the Federal Reserve and Lender Processing Services, there were $750 billion in option ARMs created between 2004 and 2007. He is specifically dealing with the ones created in 2005 and 2006, which are set to recast in 2010 and 2011, a total of $134 billion.

Using “admittedly spotty” data from LPS, he estimates that some 43% of option ARMs have been taken off the books, either through being paid off, modified or going into default. That leaves about $70 billion set to recast in the next two years. While some will go into default, not all of them will. The later group, Ezrati said, includes a number of people who are underwater on their mortgage and elect not to ruin their credit and thus decide not to walk away.

“Even if all did, the default would come to only six-tenths of 1% of all outstanding mortgages. More likely, the net addition to overall mortgage defaults will come in below 50 basis points,” he said. Ezrati later added he would be very surprised if more than 30% of those option ARMs go bust.

There is no reason for the market to panic, he continued, explaining even if his projection is “grossly wrong” and defaults are two or three times worse, options ARMs are still not the threat to the marketplace the way things like subprime mortgages and credit default swaps were.

To one industry observer, who thinks Ezrati’s probably right regarding his prediction that option ARM-related defaults will add less than 50 bps to the overall default picture, the dollar amount involved is still significant.

Marc Helm, the president of Reverse Mortgage Solutions, Spring, Texas, was at one point during his career a senior vice president at Washington Mutual, one of the largest originators of option ARMs. Part of the problem, he said, is that there is not enough accurate data on how many option ARM loans have been eliminated from the total mortgage debt outstanding universe.

Helm makes a point similar to Ezrati, that even if these loans have or will recast into a fixed-rate mortgage at today’s current low interest rates, the borrower will still suffer from payment shock as the portion of the option ARM that went into negative amortization gets rolled into the principal.

He expects a full two-year cycle of heavy issues with option ARMs starting now, reaching its peak in September 2011 before slowing down in July 2012.

The problem could be worse than what we’ve experienced, Helm said, as property values are at an all-time low, making it enticing for the underwater homeowner to walk away. Furthermore, when the borrower first got the loan, they made a low downpayment, starting with little equity to begin with. But the saving grace, Helm said, is that if the economy comes back and properties start to appreciate again, it could keep borrowers from walking away.

He cited data that showed half of all the option ARMs originated came from four states, which are also the same ones believed to be hit hardest by the property value bust: California, Nevada, Arizona and Florida.

So even if option ARMs add only 50 bps to the total delinquency category, the dollar amounts involved means the industry will take high losses on these loans, Helm said.

It could be the largest losses per loan the industry has seen to date, he added.